Why Are My PTO Payout Taxes So High?
Your PTO payout is taxed differently than regular pay. Discover why more is withheld upfront and how this amount is reconciled on your annual tax return.
Receiving a payout for unused paid time off (PTO) can feel like a bonus, but the amount is often smaller than expected due to taxes. This happens because the Internal Revenue Service (IRS) views these lump-sum payments differently than a regular paycheck. A PTO payout is received when you leave a job and your former employer pays you for accrued vacation or sick days, or if your company offers an annual cash-out option. In either scenario, this payment is considered taxable income, and the large deduction stems directly from specific tax withholding rules.
Tax Classification of PTO Payouts
The reason a PTO payout is taxed at a high rate is its classification by the IRS as “supplemental wages,” not regular salary. Supplemental wages are payments made to an employee outside of their regular, recurring pay, such as bonuses, commissions, overtime, and PTO cash-outs. The logic is that these payments are not part of the standard, predictable income an employee receives each pay period.
This distinction triggers different tax withholding procedures than those applied to a regular paycheck, where withholding is based on your Form W-4. It is not that the final tax on this money is higher, but the amount set aside for taxes at the time of payment can be larger. This classification is the foundation for the withholding methods employers are permitted to use.
Federal Income Tax Withholding Methods
When an employer issues a PTO payout, they must withhold federal income tax and have two methods to choose from for supplemental wages. The first option is the “percentage method,” where the employer withholds a flat 22% from the entire payout for federal income tax. This rate applies to all supplemental income an employee receives until the total for the year reaches $1 million, at which point the rate increases to 37%. For most employees, the 22% rate is what applies.
The second option is the “aggregate method,” which can result in a higher initial withholding. With this approach, the employer combines the PTO payout with the employee’s regular wages for that pay period. The withholding is then calculated on the total amount as if it were a single, large paycheck. This method uses standard income tax tables, but the temporary spike in income can push the employee into a higher tax bracket for that one pay period.
For example, if an employee who earns $2,000 bi-weekly receives a $5,000 PTO payout, the employer calculates withholding based on a $7,000 bi-weekly income. The payroll system assumes the employee will earn that high amount every pay period for the rest of the year, causing a large amount of tax to be withheld from that single check. Both methods are about tax withholding—a prepayment of your estimated taxes—not the final amount of tax you will owe.
FICA and State Tax Obligations
Beyond federal income tax, a PTO payout is also subject to other mandatory payroll taxes, which further reduces the net amount you receive. These taxes are calculated on the gross amount of the payout before any other deductions. The most significant are the Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare. These are applied to your PTO payout just as they are to your regular wages.
FICA taxes consist of two components. The first is Social Security tax, withheld at 6.2% on earnings up to the annual wage base limit of $176,100 for 2025. The second is Medicare tax, withheld at 1.45% with no wage limit. Together, these taxes amount to a 7.65% reduction from your gross payout, separate from federal income tax withholding.
Furthermore, state and local income taxes must also be withheld from the payout. The rules and rates for this withholding vary considerably depending on the state and sometimes the city or county where you work, contributing to the total amount withheld.
Annual Tax Return Reporting and Reconciliation
The high amount of tax withheld from a PTO payout is not your final tax liability, as the process of filing your annual tax return reconciles the difference. Your employer is required to report all income and withholdings on your Form W-2 at the end of the year. The gross amount of your PTO payout is included with your regular salary in Box 1 (Wages, tips, other compensation), and the taxes withheld are included in boxes like Box 2 (Federal income tax withheld).
When you file your federal income tax return using Form 1040, you report your total income for the entire year from all sources. Your final tax liability is then calculated based on this total annual income, your filing status, and the applicable marginal tax brackets. All the tax withheld during the year, including from your PTO payout, is treated as a payment toward this final tax bill.
If the flat 22% rate or the aggregate method resulted in more tax being withheld than you actually owe, that excess amount is credited back to you. This overpayment will either increase your tax refund or decrease the amount of tax you owe. Ultimately, the year-end reconciliation ensures you only pay the correct amount of tax required by law.